Economists' bunk exposed (1984)

From the March 1984 issue of the Socialist Standard

With understandable glee the Keynesians have greeted an attack on the monetarist doctrines of Professor Milton Friedman by Hendry and Ericsson, which, according to the Guardian (15 December 1983), is to be published by the Bank of England. The Guardian had two articles on it, both by Christopher Huhne — “Monetarists' Guru Distorts His Evidence”, and “Why Milton's Monetarism is Bunk”.

The articles set out at length the case against Friedman and include the statement that he had been supplied with a copy ‘two months ago, but has not yet responded'. The authors of the attack do not themselves claim that it destroys the monetarist case; only that the evidence on which Friedman has relied to support it is grossly defective. It will still be open to Friedman to present other evidence. Whether or not Friedman succeeds in rebutting the attack is of great importance to both the Keynesians and the monetarists but it need not concern us. Monetarist doctrine is indeed wholly fallacious, but for quite a different reason, and it did not have to wait for the publication of the new attack. It was for example dealt with in the Socialist Standard in January 1983. What does matter is whether Marx’s explanation of the several factors which determine the price level, and its rises and falls, is correct.

One red-herring trailed by Friedman has first to be disposed of, that is his nonsensical claim that Marx was a monetarist. In an interview in the Observer (26 September 1982) Friedman said: “Let me inform you that among my fellow monetarists was Karl Marx”. He explained how he arrived at this conclusion.

  Monetarism . . . was a new name for the Quantity Theory of Money which dealt with the relationship between the quantity of money and economic variables such as price level, interest rates and unemployment.

Marx did not suggest that unemployment exists because of variations in the quantity of money. In a broad sense any theory which deals with the quantity of money could be called a “quantity theory", but there was not, as Friedman implies, just one such theory. There were a number of different theories. Marx’s was unique to him and was rejected by adherents of the others. All that the Friedman interview does show is his ignorance of Marx's economics.

Marx's explanation of what determines the prices of individual commodities and what determines the general price level and its changes, involves a number of different factors: the commodity’s value (amount of labour socially necessary for its production); day-to-day fluctuations of supply and demand; the rise of prices in booms and their fall in depressions; monopoly; and, where the gold standard was in operation, changes in the value of the money-commodity, gold. In the last half-century in this country the prices of some commodities have been affected by government subsidies, which enable them to be retailed at prices below what would otherwise be their market prices.

When the British gold standard operated in the nineteenth century the paper currency (Bank of England notes) was, by law, tied to a fixed weight of gold (the pound was about ¼oz of gold). The notes could be exchanged, on demand, into the fixed weight of gold, and gold into notes. The consequence was that the purchasing power of the notes was always (except for marginal, temporary deviations) the same as that of the fixed weight of gold. There could never be a rise of prices resulting from depreciation of the notes (inflation). The price level in 1914 was almost exactly the same as in 1850, though there had been moderate rises in booms and falls in depressions in the intervening years.

With the abandonment of the gold standard in 1931 the paper currency ceased to be tied to a fixed weight of gold. It could be, and has been, massively depreciated through excess issue. The notes in circulation. under £500 million in 1938, now total over £11,000 million. The continued inscription on the £1 note, "I promise to pay the bearer on demand the sum of one pound”, is now entirely meaningless. The excess issue of notes since 1931 has been the major cause of the massive increase in the price level.

Marx dealt with this situation:

  If the paper money is in excess, if there is more of it than represents the amount of gold coins of like denomination which could actually be current it will (apart from the danger of falling into general disrepute) represent only that quantity of gold which, in accordance with the laws of the circulation of commodities, is actually required, and is alone capable of being represented by paper. If the quantity of paper money issued is, for instance. double what it ought to be, then, in actual fact, one pound has become the money name of about ⅛ of an ounce of gold instead of about ¼  of an ounce. The effect is the same as if an alteration had taken place in the function of gold as a standard of prices. The values previously expressed by the price £1 will now be expressed by the price £2. (Capital Vol. I Allen and Unwin edition, pages 108-9)

It is important to notice that Marx was not saying (as did some quantity theorists) that any increase of paper money causes prices to rise: only if it is in excess of the gold coins that would circulate. With the expansion of total production the necessary amount of gold coins would rise, as it did in the nineteenth century, with a consequent increase in the Bank of England notes without any rise of prices. Marx also pointed out that with the development of the banking system and greater use of cheques, the necessary amount of gold coins increases less fast than the increase in the volume of transactions having to be handled.

In the half century of excess issue of paper money and consequent inflation, the other factors named by Marx as affecting prices have of course continued to operate.

Where then does Marx’s explanation of inflation differ from Friedman’s theory that prices rise as a result of an increase in the amount of “money”? The explanation is that for Marx “money” meant notes and coins and nothing else. For the Friedmanites (and also for the Keynesians) “money” includes bank deposits and is predominantly made up of bank deposits. The Bank of England currently publishes half a dozen different figures for the amount of “money”, varying in size according to whether they include some or all of bank deposits, and whether they include deposits in paper money or only deposits in sterling. Some of the Bank's figures also include investments and deposits in the building societies as part of “money". Marx would have rejected all of them, as being quite irrelevant in relation to the determination of the level of prices.

So how do bank deposits come into the monetarist and the Keynesian theory of prices? Both schools are adherents of the “bank deposit theory' of prices", according to which the price level is determined by the size of bank deposits. It was stated by Keynes in his book Monetary Reform (1923, page 178).

  The internal price level is mainly determined by the amount of credit created by banks, chiefly the Big Five . . . the amount of credit, so created, is in its turn roughly measured by the volume of the banks' deposits.

Since 1977, when the Labour Government announced its intention to curb inflation by “controlling the money supply” (the policy continued by the Thatcher government), what they thought they were doing was to halt the rise of prices by controlling the size of bank deposits.

But why should the price level be affected by the size of bank deposits? The man who deposits £1,000 in a bank has the option of doing that, in which case the bank lends or spends the £1,000. or of lending or spending it himself. Why should the effect on prices be any different whichever option he chooses? The answer to this question is that the monetarists, and the Keynesians, both belong to what the late Professor Edwin Cannan so aptly described as “the mystical school of banking theorists”, the school which believes that the banks “create deposits” and thereby increase purchasing power and so increase prices above what they would otherwise be.

The banks don’t create anything. They merely lend or spend or keep in their vaults, whatever sums depositers choose to lend to them in the form of deposits — that and no more. Keynes (in the Report of the Macmillan Committee 1931, page 36) claimed that “the bulk of the deposits arise out of the action of the banks themselves”. The monetarist Milton Friedman holds the same “mystical” view. In his Free to Choose (Pelican Books. 1980, page 298) he claimed that, while the banks cannot print “the pieces of paper we carry in our pockets”, they can , and do “authorise a book keeper to make entries in ledgers, that are the equivalent of those pieces of paper”. Major Douglas, founder of the Social Credit movement, put the same daft view in his statement: “the banks have the power to create untold wealth by the stroke of a pen”.

There is abundant evidence over the years which shows that the theory that prices are determined by the size of bank deposits is fallacious; though there is sometimes the appearance of a reverse link between prices and bank deposits, in the form that when prices rise bank deposits sometimes show a rise, because people have larger money increases out of which to make deposits in banks. Neither the monetarists, nor the Keynesians, nor anybody else, have ever succeeded in showing that Marx’s statement of the several factors which affect prices is invalid.

One last note on the Guardian articles, which includes the remark: “a Treasury spokesman said last night that the Government had no intention of changing its monetarist policy”. One apparent change of intention has taken place. In the 1979 Tory election programme policy was defined as that of "controlling the money supply” (that is bank deposits). In the 1983 Tory programme the words were altered to read: “We shall continue to set out a requisite financial strategy which will gradually reduce the growth of money in circulation”.

On the face of it the reference to “money in circulation" might be taken to mean restricting the printing and circulation of the note issue, and the Bank of England has now added to its collection of definitions of “money” a new one called M nought (M0) circulation of notes and coins only.

In 1919 the Government did instruct the Bank of England to reduce the amount of notes in circulation, and niillons of pounds of notes were burned. Inflation was not only halted, but prices fell drastically. So far there is no sign that the Thatcher government intends to repeat that action, for the notes in circulation have continued to increase.

Edgar Hardcastle